On May 25, 2022, the SEC issued a release (the “Release”) containing proposed rule and form amendments under both the Advisers Act and the 1940 Act (the “Proposals”) to require registered investment advisers (“advisers”), registered investment companies and business development companies (collectively, “funds”) to disclose additional information about their ESG investment practices.
June 1, 2022 Time to Read: 20 minutes Practices: Asset Management
On May 25, 2022, the U.S. Securities and Exchange Commission (the “SEC”) issued a release (the “Release”)1 containing proposed changes to the names rule, Rule 35d-1 under the Investment Company Act of 1940, as amended (the “1940 Act”) (the “Rule”), and related form amendments (collectively, the “Proposals”).2 If adopted as proposed, the Proposals would substantially expand the Rule’s applicability and require funds to amend their prospectus disclosure. Specifically, the Proposals would:
These and other aspects of the Proposals are discussed in detail below.
The Proposals’ Broad Scope . The Proposals would broaden the scope of the Rule’s current 80% investment policy requirement to apply to fund names that “include terms suggesting that the fund focuses in investments that have, or whose issuers have, particular characteristics.” This would include fund names with terms such as “growth” or “value,” or terms indicating that the fund’s investment decisions incorporate one or more ESG factors.4 Therefore, as expanded, the Rule’s 80% requirement would apply where a fund’s name could be construed as referring to an investment strategy. The Rule’s existing 80% investment policy requirement would continue to apply to funds with names that suggest a focus on a particular type of investment or industry, or in particular countries or geographic regions, or those that suggest certain tax treatment.
Defining Terms in a Fund’s Name . Consistent with the Rule’s current requirements, the Release states that funds would be able to define terms used in their names in a reasonable way. However, in a change from the current rule, the Proposals “would require that any terms used in the fund’s name that suggest either an investment focus, or that the fund is a tax-exempt fund, must be consistent with those terms’ plain English meaning or established industry use.” According to the Release, what constitutes “reasonable” in this context could vary depending on the fund name, but “requires a meaningful nexus between the given investment and the focus suggested by the name.” Here, the Release notes that, “when the investment focus relates to an industry, there are different approaches a fund could take to determine if a given security is tied to the economic fortunes and risks associated with the named industry.”
Treatment of a Fund of Funds . The Release states that “it would generally be reasonable for a fund of funds or other acquiring fund to include the entire value of its investment in an appropriate acquired fund when calculating compliance with the 80% investment requirement without looking through to the acquired fund’s underlying investments.”6
Funds Unaffected by the Proposals . The Release notes that there will be fund names that would not require the fund to adopt an 80% investment policy because the names “would not connote an investment focus.” This would include fund names that (i) reference characteristics of a fund’s portfolio as a whole (such as a name indicating the fund seeks to achieve a certain portfolio “duration” or that the fund is “balanced”), (ii) reference elements of an investment thesis without specificity as to the particular characteristics of the component portfolio investments (such as “long/short”), (iii) suggest a possible result to be achieved (such as “real return”) or (iv) refer to a retirement target date.7
The Proposals would permit a fund to temporarily depart from the 80% investment requirement under certain specific circumstances (i) as a result of market fluctuations or other circumstances where the temporary departure is not caused by the fund’s purchase or sale of a security or the fund’s entering into or exiting an investment, (ii) to address unusually large cash inflows or unusually large redemptions, (iii) to position the portfolio in cash and cash equivalents or government securities to avoid a loss in response to adverse market, economic, political or other conditions or (iv) to reposition or liquidate a fund’s assets in connection with a reorganization, to launch the fund or, following notice of a change in the fund’s 80% investment policy, to fund shareholders at least 60 days before the change pursuant to the Rule.
Under each of these circumstances – except fund launches (where temporary departures may not exceed a period of 180 consecutive days),8 reorganizations (for which the Proposals do not specify a required time frame) or where the 60-day notice has been provided to shareholders – the Proposals would require a fund to bring its portfolio back into compliance with the 80% investment requirement within 30 consecutive days or “as soon as reasonably practicable” (whichever period is shorter). The Release notes that “as soon as reasonably practicable” would not strictly mean “as soon as possible” in all instances, but is intended “to allow for consideration by the adviser of how to return to compliance in a manner that best serves the interest of the fund and its shareholders (but in no case longer than the proposed 30-day limit where applicable).”
The Proposals address both (i) the valuation of derivatives instruments for purposes of determining compliance with a fund’s 80% investment policy and (ii) the derivatives instruments that a fund may include in its 80% investment requirement.
Use of Derivatives Instruments’ Notional Amounts . The Proposals would require a fund, in calculating its assets for purposes of compliance with the Rule, to value each of its derivatives instruments using its notional amount (subject to adjustments discussed below) and to reduce the value of its assets by excluding cash and cash equivalents up to the notional amounts of the derivatives instrument(s).
Derivatives Instruments Includes Liabilities . The Proposals’ requirement to use notional amounts would apply to all of a fund’s derivatives instruments. The requirement would apply to both the numerator and the denominator in the calculation that the fund would use to determine compliance with its 80% investment policy. Moreover, the Proposals requirement to value derivatives instruments using their notional amounts makes no distinction between derivatives instruments that are assets and derivatives instruments that are liabilities . Therefore, the Proposals would require funds, in measuring their assets when assessing compliance with its 80% investment policy, to include the notional amount of any derivatives instrument, regardless of whether the instrument is an asset or a liability.
Deduction of Cash and Cash Equivalents from Assets up to Notional Amounts . Funds that rely upon derivatives instruments to obtain exposure to the markets in which they invest may maintain portions of their assets in cash and cash equivalents.9 Thus, when assessing compliance with a fund’s 80% investment policy, the Proposals would require the deduction of cash and cash equivalents from assets (i.e., the denominator in the 80% calculation) up to the notional amounts of the fund’s derivatives instruments.
According to the Release, the approach is intended to remove from the compliance calculation cash and cash equivalents because they do not themselves provide market exposure and function as low-risk collateral for the derivatives instruments whose notional amounts already are included in the denominator. Thus, “including this collateral would effectively ‘double-count’ the fund’s exposure” and including both the derivatives instruments’ notional amounts and the value of the cash and cash equivalents “would overstate the scale of the fund’s market exposure obtained through the derivatives instruments.”
Derivatives Instruments Included in the 80% Basket . The Release acknowledges that, in addition to using derivatives instruments as direct substitutes for cash market investments, some funds use derivatives instruments to hedge exposures or to obtain exposure to market risk factors associated with the fund’s investments (e.g., interest rate risk, credit spread risk and foreign currency risk). The Release states that, if amended Rule 35d-1 “did not allow funds to treat the notional amounts of those derivatives instruments as investments that reflect the fund’s investment focus, the notional amounts of those derivatives instruments could cause a fund to fall out of compliance with its 80% investment policy.”
Some funds are either a registered closed-end investment company or a business development company (a “BDC”) whose shares are not listed on a national securities exchange (together, “unlisted closed-end funds and BDCs”). The Proposals would require the 80% investment policy of unlisted closed-end funds and BDCs to be a fundamental investment policy.
The Proposals would include a new provision in the Rule providing that a fund’s name may be materially deceptive or misleading under Section 35(d) even if the fund adopts an 80% investment policy and otherwise complies with the Rule’s requirement to adopt and implement the policy. The Release notes that the SEC has previously stated that the Rule’s 80% investment policy requirement is not intended to create a safe harbor for fund names, and the Proposals, if adopted, would codify this view to make clear that a fund name may be materially deceptive or misleading even where the fund complies with its 80% investment policy.
The current Rule requires and, with the Proposals’ amendments, would continue to require, a fund to invest at least 80% of its assets consistent with its name, but does not prescribe how the fund invests the remaining 20%. The Release notes that a fund’s name could be materially deceptive or misleading for purposes of Section 35(d) if, for example, a fund complies with its 80% investment policy but makes a substantial investment that is antithetical to the fund’s investment focus (e.g., a “fossil fuel-free” fund making a substantial investment in an issuer with fossil fuel reserves). Similarly, a fund’s name could be materially deceptive or misleading for purposes of Section 35(d) if the fund invests in a way such that the source of a substantial portion of the fund’s risk or returns is different from those that an investor reasonably would expect based on the fund’s name, regardless of the fund’s compliance with the requirements of the Rule (e.g., a short-term bond fund using the 20% basket to invest in highly volatile equity securities that introduce significant volatility into a fund that investors would expect to have lower levels of volatility associated with short-term bonds).
The Proposals include amendments to registration forms (Form N-1A, Form N-2, Form N-8B-2 and Form S-6) that would require any fund that is required to adopt and implement an 80% investment policy to include prospectus disclosure defining the terms used in the fund’s name, including the specific criteria the fund uses to choose the investments described by the terms. In addition, funds would be required to tag this new information using a structured data language (“Inline XBRL”).
The Proposals specifically address what the Release calls “integration funds,” which the Proposals describe as funds that consider one or more ESG factors alongside other, non-ESG factors in the fund’s investment decisions but those ESG factors are generally no more significant than other factors in the investment selection process, such that ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.
The Proposals would provide that the name of an “integration fund” is materially deceptive and misleading if the fund’s name includes terms “suggesting that the fund’s investment decisions incorporate one or more ESG factors.” The Release states that this approach to integration funds makes clear that “it would be misleading for a fund for which ESG factors are generally no more significant than other factors in the investment selection process to include ESG terminology in its name, as this has the potential to overstate the importance of the ESG factors in the fund’s selection of its portfolio investments.” Therefore, a fund would be prohibited from using terms such as “ESG” or “sustainable” in its name where ESG inputs are merely one factor among many driving an investment decision. The inclusion of ESG terminology in a fund’s name “would be materially deceptive and misleading unless a fund prioritizes those ESG considerations that their names suggest, as contrasted to funds that analyze ESG factors only as part of a broader investment selection process.”
The Proposals would amend the Rule to include changes to the current notice requirement, which now requires 60 days’ notice to fund shareholders of any change in the fund’s 80% investment policy.
The Proposals would amend Form N-PORT to include a new reporting item requiring registered funds (other than money market funds and BDCs) that are required to adopt an 80% investment policy to report on Form N-PORT (i) the value of the fund’s 80% basket, as a percentage of the value of the fund’s assets and (ii) if applicable, the number of days that the value of the fund’s 80% basket fell below 80% of the value of the fund’s assets during the reporting period. Funds subject to this reporting would be required to provide this information as of the end of the reporting period, and the information would be publicly available for the third month of each of the fund’s fiscal quarters.
The Proposals also would amend Form N-PORT to include a new reporting item requiring a registered fund that is subject to the 80% investment policy requirement to indicate, with respect to each portfolio investment, whether the investment is included in the fund’s 80% basket. This information would be publicly available for the third month of each of the fund’s fiscal quarters.
The Proposals would require funds to maintain certain records depending on whether the fund would be required to adopt an 80% investment policy.
Funds Required to Adopt an 80% Investment Policy . The Proposals would require a fund that is required to adopt an 80% investment policy to maintain written records of the following to document its compliance under the 80% investment policy provisions of the Rule.
Funds That Do Not Adopt an 80% Investment Policy . The Proposals would require a fund that does not adopt an 80% investment policy to maintain a written record of the fund’s analysis that such a policy is not required under the Rule.
The Proposals would include certain exceptions for unit investment trusts (“UITs”) that have made their initial deposit of securities prior to the effective date of any amendments to the Rule that the SEC adopts. These UITs would be exempt from the requirements to adopt an 80% investment policy and the recordkeeping requirements, including recordkeeping for funds that do not adopt an 80% investment policy, unless the UIT has already adopted – or was required to adopt at the time of the initial deposit – an 80% investment policy under the now existing form of the Rule.
In addition, all UITs would be subject to the Proposals’ other requirements. Consequently, UITs would be subject to the proposed plain English requirements, as well as the requirements to make prospectus disclosures that would be mandated by the Proposals and to tag newly required information in the prospectus using Inline XBRL.
The Release states that comments on the Proposals should be received by the SEC no later than 60 days after publication of the Release in the Federal Register. As of the date of this Alert, the Release has not been published therein.
If you would like to learn more about the issues in this Alert, please contact your usual Ropes & Gray attorney contacts.
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